Thursday, November 29, 2012

Goodhart's Law is the notion that when a central bank begins to respond to an indicator of monetary conditions, market participants will come to expect those responses and trade on that basis. The result can be an indicator of monetary policy that changes however market participants believe the central bank wants it to change.

For example, simple Keynesian monetary analysis suggests that an increase in the demand to hold money will result in higher money market interest rates. It would seem reasonable that a central bank would watch money market interest rates, and when they rise, increase the quantity of money to accommodate the increase in the demand for money.

Goodhart's law, however, suggests that market participants will come to expect this behavior by the central bank. If interest rates were to rise, there would be a strong tendency by market participants to postpone security sales and an added motivation to purchase securities. Alternatively, lenders would rush to take advantage of the ephemerally higher rates, while borrowers would wait for them to fall again. In the limit, actual market interest rates would not change at all, remaining exactly where the market believes the central bank wants them. With no changes in interest rates actually occurring, such interest rates provide no information on actual monetary conditions.

If the central bank's goal is to keep money market interest rates at a certain level, then this isn't a problem. It is only a problem if the central bank has some other goal, and is using interest rates as an indicator as to whether monetary conditions are consistent with achieving that other goal.

Consider inflation targeting. If inflation expectations are well anchored, then there will be a tendency for those actually setting prices to raise them at the rate the central bank believes is appropriate. Suppose that prices would rise by less. The typical product is relatively cheap, and so there is an incentive to postpone sales and anticipate future purchases. In the limit, prices continue to rise at the rate the market believes the central bank believes is appropriate.

If the goal is to keep inflation on target, then this isn't a problem. Inflation stays on target despite spending on output failing to shift with productive capacity. If, on the other hand, changes in inflation are used as a signal that spending on output is different from productive capacity, then Goodhart's Law suggests the signal is attenuated. Strongly anchored inflation expectations makes inflation a poor signal of an output gap.

Taylor-rule regimes have two characteristics that help solve that problem. Most importantly, conventional monetary policy depends on the output gap as well as the inflation rate. If the inflation rate were very sticky due to Goodhart's Law, then the observed output gap will result in shifts in monetary policy that bring spending on output back into equilibrium with productive capacity.

Those economists (apparently including Taylor himself,) who advocate focusing solely on inflation would take away that benefit of the Taylor rule. Under such a system, fluctuations in spending on output, in real output, and employment could occur even while the inflation rate remains on target. Further, to the degree that output gaps are measured by observing changes in inflation, then Goodhart's Law suggests that output gaps will consistently underestimated, and changes in output in response to changes in spending will be identified as changes in spending and output matching changes in potential output. In other words, inflation fails to change and while output does change, the failure of inflation to change results in a change in the estimate of potential output.

The other characteristic of the Taylor rule that helps solve this problem is inflation rather than price level (growth path) targeting. Suppose that a monetary authority targeted the growth path of the price level. The motivation to keep actual prices on the target growth path would be much stronger if any temporary deviation were rapidly reversed. For example, if prices actually did rise only one percent, they would be expected to rise 3% to return to the trend. This more rapid increase in future prices gives a stronger incentive to postpone sales and increase purchases in anticipation of the price increases relative to a regime where prices are just expected to rise 2% from the current level.

However, much of this intuition implicitly assumes market clearing. If firms are setting prices and wages based upon what they think everyone else will be doing, then the central bank's 2 percent target creates a pretty obvious Schelling point. Our pay offers must be consistent with inflation. Our prices must cover our costs, including the wage bill. Individual firms sales should expand if prices increase slightly less than what other firms are going to charge.

Paradoxically, if every single firm raises prices at the target inflation rate always, then the result is the exact same thing as a price level target. A firm raises prices 2 percent, and sales are disappointing. Do they raise prices less next period? Not if they expect sales to improve enough to clear markets give a 2% price increase.

Suppose they finally give up on the central bank and raise prices more slowly. The central bank now gets the signal that demand is growing too slowly. And what does the firm do next? Do they continue to raise prices more slowly, or do they go back to raising prices 2 percent? The central bank is supposed to raise demand enough so that raising prices 2% will clear markets. And then, does the central bank determine that everything is good because inflation is on target--prices rose 2%?

What is the solution to this problem? Naturally, I would argue that it is nominal GDP level targeting. Suppose Goodhart's Law somehow causes firms to keep nominal GDP on target. In my view, that isn't a problem. Just like someone who believes that the sole goal of monetary policy is to keep inflation on target, I think that the sole goal of monetary policy should be to keep spending on output on target. If market participants keep nominal GDP on target in anticipation of the monetary authority's actions, then that is an advantage. Spending is where it should be.

Tuesday, November 27, 2012

Paul Krugman has been dismissing concerns about bond vigilantes. From the point view of a Market Monetarist, bond vigilantes are bad, but there is a silver lining to their cloud. And it is that silver lining which provides the element of truth to Krugman's argument.

I think Krugman's framing is that "other people" are claiming that it is necessary to raise taxes and cut government spending soon in order to reduce the budget deficit. Yes, this will tend to slow or reduce spending on output and so slow the already weak recovery or force the economy back into recession. But, according to some, if we don't deal with the budget deficit soon, the bond vigilantes will strike. They will sell off bonds and force up interest rates. The higher interest rates will tend to slow or reduce spending on output and so weaken the weak recovery further or return the economy to recession.

I think Krugman is arguing that this is wrong, and that when the bond vigilantes strike, they force down the value of the dollar, and so increase spending on domestic output--more spending on exports and more spending on import competing goods. Fiscal austerity, then, will tend to depress spending on output, while an attack of the bond vigilantes will have the opposite effect. The notion that we are going to have slower spending on output anyway, so we might as well reduce the budget deficit, is wrong.

From a Market Monetarist perspective, monetary policy can and should be used to keep nominal spending on output on target. With a competent monetary authority, bond vigilantes won't have any effect on total spending on output. Still, if people holding government bonds expect that the monetary regime will hold, but government will explicitly default, or else the regime will break down and money will be created to pay off the debt, or that the real exchange rate will later depreciate so that holding U.S. bonds is less attractive than foreign bonds, there can be an immediate sell off of bonds and depreciation of the U.S. currency.

The decrease in the value of the dollar results in higher prices of imported consumer goods and lower real incomes. The reason for the lower real incomes is the less advantageous terms of trade. To keep spending on output from rising above target, market interest rates must increase. Those fixated on interest rate targeting would frame this as the central bank raising its target interest rate to dampen increases in spending.

From a Market Monetarist perspective, selling off bonds lowers their prices and raises their yields. This does tend to reduce spending on all sorts of output, but this is just offsetting the increases in spending on import competing goods and export goods. If the higher interest rates result in people choosing to hold less money, then the monetary authority should reduce the quantity of money, keeping an excess supply of money from pushing spending on output above target.

As for the government's budget, it now has a greater interest expense. It must either raise taxes or else cut government outlays other than interest. Whatever benefits those government programs provided are sacrificed, while those paying higher taxes or receiving reduced transfers will enjoy fewer consumer goods and services either now or in the future. Since much of the U.S. debt is held externally, it is pretty clear that those domestic reductions in well being go to pay off foreign debt, which is the other side of the coin of the additional exports and reduced imports.

That is all bad.

Now, Market Monetarists believe that spending on output is currently too low, well below the growth path of the Great Moderation and below an appropriate start for a new regime. For example, I believe that a Reagan/Volcker nominal recovery is in order, before starting with slow steady nominal spending growth. If the bond vigilantes attacked, and spending on output was allowed to rise rapidly, then this would help generate an appropriately rapid nominal recovery. This is the element of truth in Krugman's perspective.

To the degree that real output and employment expand due to more rapid growth in spending, then this added real output (a closing on the output gap,) will partly or perhaps fully offset the adverse effects of the lower exchange rate and higher interest rates. To some degree, formerly unemployed resources would be used to produce the export goods that pay back the foreigners. The reductions in the transfers received and increase in the taxes paid by the formerly unemployed would help fund the increase in interest expense on the national debt.

But, of course, Market Monetarists (unlike Krugman,) believe that it is in the power of the Fed to bring about a rapid nominal recovery without an attack by the bond vigilantes. And so, there is really no particular benefit to such an attack. Further, Market Monetarists believe that the Fed can offset the effect of any fiscal austerity, and so, prefer that fiscal policy be aimed at efficiently funding an appropriately-sized government. It is the monetary authority's job to make sure that adjustments in fiscal policy, like the myriads of other things that might impact various elements of spending on output, remain consistent with the nominal anchor--ideally a target growth path for spending on output.

If, on the other hand, the Fed were to target the exchange rate, then an attack of the bond vigilantes would require a rapid contraction in spending on output. Further, a focus on inflation, at least of consumer goods, would also require a contraction of spending on output to prevent the inflation of the prices of imported consumer goods.

This second scenario is very realistic, and so, unless inflation is running below target, an attack by the bond vigilantes could be very contractionary. It seems to me that this is the framing that those favoring fiscal austerity have in mind when they worry about the threat of the bond vigilantes. For a Market Monetarist, inflation targeting is a bad idea, and exchange rate targeting is worse.

Monday, November 26, 2012

Foreign Policy magazine has listed Scott Sumner as one of the top 100 thinkers of the year. He tied with Bernanke at 15! Great news. I was a bit troubled by some of the brief article. It read almost as if Scott advocates targeting real output.

His big idea is nominal GDP targeting, the notion that the Fed's policies should be focused on economic growth rather than inflation rates. As Sumner explains, "it's about setting specific goals and promising to do whatever one can to meet those goals." This means the Fed should keep up aggressive easing and inject money into the financial system until growth returns -- inflation be damned.

No mention of level targeting (the journalists mostly miss that.) While it is true that Market Monetarists really do think that inflation should be ignored, a target for the growth path of nominal GDP implies limits on inflation rates. And Market Monetarists do typically favor open market operations, which inject money into the financial system, and favor doing whatever is necessary to generate the nominal growth to get and keep spending on output on target, that isn't at all the same thing as creating growth in real output. In the very same way that Market Monetarists believe that inflation should be ignored, real output growth should also be ignored by the Fed. The Fed's sole duty should be to keep spending on output growing on a target growth path. How much inflation and real growth is generated should be left to market forces, and not micromanaged by the Fed.

Saturday, November 24, 2012

The solution to the problem of the "Fiscal Cliff" is simple: Nominal GDP level targeting. The reallocations of resources made necessary by the increases in taxes and reductions in military and nonmilitary discretionary spending would occur in the context of expectations of growing spending on output. To the degree that the reallocation of resources temporarily reduces output, those sectors of the economy where demand will increase can expect rising prices and higher profits.

Unfortunately, the Fed remains wed to interest rate and inflation targeting. A decrease in the budget deficit is an increase in national saving. Other things being equal, the natural interest rate falls. This brings investment and national savings back into equilibrium. This would occur by a decrease in the quantity of private saving supplied--more spending on consumer goods and services and an increase in the quantity of investment demanded--more spending on capital goods. Since the higher taxes will tend to depress spending on both consumer and capital goods, much of this adjustment is simply a reallocation of private expenditure. Still, total private spending of some sort needs to expand to offset the reduced spending on government goods and services.

With the Fed's preferred interest rate target already very low, the Fed cannot make what would be a qualitatively correct response--lower the target interest rate. The Fed, presumably, will continue to flail around, perhaps expanding its asset purchasing program. That would also be the qualitatively correct approach.

As for inflation targeting, this implies that the competition of those losing employment in the government must slow wage increases for those who continue to be employed. This will slow wage increases, and expand profits in those sectors of the economy with growing demand. This should result in increased hires in those sectors. This process appears to be remarkably slow and ineffective lately.

So, if the Fed continues witn interest rate and inflation targeting, the "Fiscal Cliff" will cause problems. With nominal GDP level targeting, these problems are less severe.

Of course, the "Fiscal Cliff" has other implications as well. It isn't just about spending on output.

The end of the Bush tax cuts and increase in every one's marginal tax rates is undesirable. Still, these things should be kept in perspective. In 1980, the top marginal tax rate was 70 percent. And while I did support the Bush tax cuts, I certainly considered it a less than ideal approach. Rather than across the board cuts in marginal tax rates, I favor the choice of a low flat tax

Also, the Bush tax cuts were not implemented with a program of government spending cuts, but rather where implemented along with big government Republicanism--an orgy of government spending. The reason the tax cuts had a 10 year time limit was that the positive impact on the tax base of the lower marginal rates, as well as restraint in government spending, would result in lower budget deficits. That failed. Budget deficits are vast.

And so, my view is that across the board cuts in tax rates are better than nothing, (though much worse than a complete tax overhaul,) but any such tax cuts should be combined with a program of smaller government--reduced government spending. This is the deal for voters--you have to give up government benefits to get lower taxes. And, of course, you have to put up with higher taxes to get more government benefits.

And so, we are back where we were in the early part of the 21st century. Back to the drawing board.

Friday, November 23, 2012

Marcus Nunes posted the following report from the Cato Monetary Conference in a comment on Sumner's Money Illusion:

"One young man asked whether the adoption of a nominal GDP target would satisfy Mr Taylor’s desire for the Fed to be governed by rules rather than the whims of policymakers. Mr Taylor had no problem with steady nominal GDP growth as a goal of monetary policy but he did not see how a rule along the lines of “keep NGDP on its trend path” would be useful because it does not address how to achieve this objective. Expectations matter, he noted, but they are nothing without actions that justify those expectations. A policy rule is useless if it does not to relate to the instruments at the disposal of policymakers."

This points to a paradox regarding rules and discretion. Are the consequences of a rule desirable, or at least, tolerable? Market monetarists argue that nominal GDP level targeting has consequences are tolerable, and more to the point, better than the alternatives. Unfortunately, the direct actions of a central bank can only impact nominal GDP--spending on output--by influencing the spending decisions of millions of households and firms.

While this suggests that the direct actions of the central bank might not be able to influence the choices of those households and firms so that nominal GDP cannot be kept on target, perhaps more to the point, central banks have no confidence in their ability to keep nominal GDP on a target. They prefer to commit to doing things that they are confident they can accomplish.

And what do central banks feel they can accomplish?

First, what can they actually do directly? They can purchase specific amounts of particular assets--what has come to be called quantitative easing. Or, they can control the total amount of their liabilities--targeting base money. (Market monetarists, like other monetarists, tend to fixate on this) They can also control the interest rates at which they make loans to banks--the discount rate in the U.S. (or primary and secondary credit rates.) And they can directly control the interest rate they pay on the reserve balances that banks hold with them.

However, it is clear that some of those things that central banks can do, they have little interest in doing. As all monetarists know, getting a central bank to make some kind of commitment regarding base money is nearly impossible. While they have been willing to commit to purchasing certain types and amounts of financial assets, they don't seem very comfortable following that approach.

No, they like to manipulate supply and demand conditions in short term credit markets so that some kind of market interest rate is on target. They keep short term interest rates steady, and then at periodic meetings, they decide to make adjustments. In the US, the Fed uses the federal funds rate as a benchmark. (Interestingly, when other short term interest rates failed to move with the federal funds rate in 2008, the Fed began all sorts of new interventions to directly impact other short term rates.) Clearly, the Fed believes that it can "control" short term market interest rates, even though this control is indirect for anything other than the interest rate the Fed itself charges on the loans it makes or pays on the deposits it accepts.

Of course, keeping short term interest at some particular level is not a tolerable rule. If interest rates (either nominal or real) are set too low, the result is a hyperinflationary disaster. If, on the other hand, interest rates are set too high, the result would be an equally disastrous deflationary depression.

Central bankers appear to have learned that they must adjust the interest rates they "control" to prevent disaster. Rising consumer prices and rising unemployment both upset voters, and so, indirectly, the politicians. If consumer prices start rising to much, central banks have learned that they must raise interest rates and if unemployment starts to rise too much, they need to lower interest rates.

If we look at a period where inflation and unemployment both remained acceptably low, like the Great Moderation, then we can see exactly how much the central bank adjusted interest rates during those period where inflation or unemployment began to rise. We can then advise central bankers to continue with that approach. If the "natural" unemployment rate is steady over the period, then the changes in unemployment would reflect deviations of the unemployment from the natural rate. So, the central banks actions can be characterized as responding to inflation and deviations of real GDP from potential GDP.

Keeping inflation at a low, steady rate, and real GDP close to potential is a tolerable rule. Of course, central banks can only influence inflation and real GDP through the spending decisions of millions of households and firms--much like the level of nominal GDP. (The primary difference between nominal GDP and inflation and unemployment is that voters don't care about nominal GDP statistics, but they do care about inflation and unemployment.)

What Taylor proposes is to take the observed relationship between the interest rates that a central bank "sets" and inflation and the real GDP gap (which is related to the unemployment rate that voters and politicians worry about,) and then tell central bankers to continue to adjust interest rates in that fashion. Take what was their discretionary response to money market conditions constrained by the need to avoid excessive inflation and unemployment, and make that into a mechanical rule.

If the relationship between inflation, unemployment, and short term interest rates remain similar to those that held over the "good" period, then such an approach seems reasonable. But what happens when conditions change?

In my view, the notion that economists can develop a simple formula relating something that central bankers are confident they can control and those things that it is at least tolerable to control, is hubris. Sure, it appears that it is possible to find some useful rules of thumb that work in some times and and some places. But reifying those rules of thumb into binding constraints on a central bank is an error. (Of course, in practice, central banks have followed such rules just as long as they felt like it. When they believe conditions have changed, they quit following them.)

In my view, the binding constraint on the central bank should be something that is tolerable--nominal GDP level targeting. If central banks can develop rules of thumb that relate something they are confident they can control--like short term interest rates--to the level of nominal GDP, then that is just fine. But when the rule of thumb breaks down, the central bankers need to change what they are doing.

For example, when the rule mandates a lower short and safe interest rate, and it is already at zero, then the central bank needs to drop the rule of thumb and seamlessly shift to raising the level of base money. If the relationship between short and safe interest rates and other interest rates change, there should be no notion that the central bank needs to get all the other interest rates to move so that they have the "proper" (really the past) relationship with short and safe interest rates. If the rule of thumb breaks down, then adjust the short and safe interest rates more than ordered by the broken rule.

To sum up, the paradox is that those things that it is sensible, or at least tolerable, for a central bank to control, the central banks have no confidence in their ability to control. And those things that the central banks have confidence in their ability to control can lead to intolerable macroeconomic consequences. It is to avoid those disasters, or at least intolerable macroeconomic results, that central banks need to be limited by rules.

I think the answer is discretion subject to constraint. Some way needs to be developed so that those actually issuing money can adjust the interest rates they pay and charge and/or the quantities of monetary liabilities they issue, subject to the constraint that the expected value of some relevant nominal quantity remains anchored.

I think the least bad nominal anchor is a steady growth path for nominal GDP. While index futures targeting (or convertibility) is a promising approach that deserves more research, the least bad option today is to allow a central bank discretion to manipulate those things it directly controls subject to the constraint that it try to keep nominal GDP on target is the least bad approach. In my view, the first step is for Congress to legislate the target growth path and then hold the central bankers accountable for hitting that target. If they fail, then they can appear before Congress and explain why. And they can also explain what they are doing differently to try to get nominal GDP to the target growth path.

Tuesday, November 6, 2012

Miles Kimball has an article on Quartz about electronic money. He advocates making electronic money the medium of account, and allowing tangible paper currency to trade at a discount during national economic emergencies.

He proposes that households and firms have electronic money created by the government available, though he doesn't really spell that out. He mentions in passing that the interest rate paid on that electronic money (effectively "reserve balances" held by firms and households at the central bank) should be set below the interest rate target set by the Fed. Perhaps I was reading between the lines, but he seems to be advocating a system of using the interest rate paid on the banks' reserve balances as the instrument of monetary policy. His major emphasis is that this target interest rate could be reduced below zero if the Fed found it necessary to do so in order to maintain spending on output.

As for tangible hand-to-hand currency, it would trade at a growing discount relative to the electronic money held by households and firms. While Kimball doesn't explain, I suppose he is assuming that by reducing the price at which currency can be deposited in exchange for electronic money in the future, its actual market value would fall. (I think this is likely true.)

This discount on tangible currency would only occur in national economic emergencies--that is--when the interest rate that banks earn on reserve balances is reduced to very low levels. Again, while Kimball wasn't too clear, when the interest rate the Fed pays to banks rises enough that the lower one paid to firms and households rises enough, so that the still lower rate of price decrease on the tangible currency hits zero, then tangible currencywould no long fall in value. When good times return, he explains, the discount would be reduced (the price of currency would rise again) creating a positive rate of interest, presumably still slightly lower than that on electronic money. The point is to make tangible currency perform slightly worse than a balance in an electronic money account.

In my view, there is no need to set up deposit accounts for households and firms at the central bank (Kimball's "electronic money.") The private banking system already provides those--they are called checkable deposits. It would be possible for the government to adjust the rate of exchange between reserve balances and currency at the central bank and allow private banks to use that same rate of exchange for withdrawals and deposits of the tangible currency. The key, however, isn't how much currency can be withdrawn from deposits, but rather the price at which it will be accepted for deposit in the future. A dollar withdrawn when interest rates turn negative must be only accepted for deposit when interest rates turn positive again at a lower price reflecting the negative interest rate on deposits during the interim.

I still believe that rather than have the government develop a new sort of money for households and firms (electronic deposits held directly at the central bank,) it would be better to leave the issue of the tangible currency to the private sector.

In my view, a situation where extremely low (and even negative) yields on short and safe assets makes currency more attractive to hold, is not a time to start reducing the price of currency. The growing discount on currency means that each dollar-dominated deposit is being redeemed with progressively more hand to hand currency. While that make it more attractive to hold deposits, (with the nominal interest rate calculated in terms of the currency remaining approximately zero,) for this to all work out, the government must stick to its commitment to only allow the currency to be redeposited at that lower price. Or rather, to only gradually raise the price at which it can be deposited at a rate reflecting interest rates on other short and safe assets when they are again positive. Allowing that process to be short circuited, and having the currency jump back to par would be a problem. And why wouldn't everyone in the private sector clamor for such a jump in the value of their currency holdings?

In my view, private hand-to-hand currency, where banks just cease issuing it when it is no longer profitable, and have a call provision when maintaining the outstanding balance is too costly, is a much better system. Rather than trying to reduce the price of currency, the central bank just sets the interest rate it pays on deposits where it thinks it is best. Banks set interest rates on "electronic money" as they think is best. And if no one wants to issue currency, then none is issued.

Sure, the lack of hand-to-hand currency is inconvenient. Let the private sector come up with substitutes to solve the problem of currency shortages. I think it is simpler than managing a currency deposit exchange rate.